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State and Local Government Expenditures (Chapter-10)

State and Local Government Expenditures- Background

• Question: How much (if any) should the national (federal) government intervene in the provision of public goods?

• What is the optimal level of fiscal federalism?– Optimal fiscal federalism: The question of

which activities should take place at which level of government.


• Example: Bush administration’s No Child Left Behind (NCLB) policy

– NCLB aims at improving the educational opportunities for disadvantaged students by holding ‘failing’ schools accountable.

– Harsh penalties, including elimination of principles and teachers were to be imposed on schools failing to show ‘adequate’ progress.

– The adequate progress would be measured based on a standardized national test.


• Example: Bush administration’s No Child Left Behind (NCLB) policy

– Proponents: Supported the federal government for intervening when it is clear that many states have failed or not even tried to close the achievement gap between white and black students.

– Opponents: Testing students on a nationally standardized test might not reflect the varying tastes of individuals across different localities.

– How much should the federal government intervene in the provision of education, which is a public good?

State and Local Government Expenditures-Fiscal Federalism

• Changing fiscal federalism in the United States over the years:


• Spending and Revenues:

– Federal

• Spending: Health care, national defense and social security

• Revenues: Majority from income taxation.

– State

• Spending: Education, health care and public safety.

• Revenues: Majority from property taxation.


• Fiscal federalism among OECD countries:

State and Local Government Expenditures-Optimal Fiscal Federalism

• Two major problems with government provision of public goods:

– Preference revelation: People may misrepresent their preferences of the public goods.

– Preference aggregation: Difficult to design mechanisms to aggregate individual preferences into social decisions.


• Tiebout Model:

– According to Tiebout, the problems with public good provision were missing ‘shopping’ and ‘competition’ in the market.

• Individuals ‘shop’ for public goods and choose the locality that provides the public good according to their tastes (competition).

• In other words, individuals ‘vote with their feet’.

– Under certain conditions, provision of public goods will be fully efficient at the local level.


• Tiebout Model:

– Example: Two individuals, one public good. Assume that individual-1 prefers a higher level of public good than individual-2.

• Tiebout model predicts that individual-1 moves to a locality with individuals who prefer exactly the same amount of the public good.


• Tiebout Model:


• No need for individual-1 to underreport his willingness to pay for the public good, since if he does so, he would have to move to a locality that provides lower levels of public good.

• No preference revelation issue!


• Tiebout Model:


• No preference aggregation issue either, since each locality is homogeneous in terms of citizens’preferences for the public good.


• Issues with the Tiebout Model:

– Assumes costless moving.

– Assumes that individuals have perfect

information about the localities’ provisions of public goods.

– Provision of some public goods require sufficient size or scale.

• Example: Public schools.


• Issues with the Tiebout Model:

– Requires lump-sum taxation, which is problematic, since it does not take into account the varying wealth of individuals.

– Requires no spillovers/ externalities:

• Spillover example: local park

• Externality example: police force and crime.


• Evidence of the Tiebout Model:

– Residence similarity across areas

– Capitalization of fiscal differences into housing prices


• What are the normative implications of the Tiebout model for the optimal design of fiscal federalism?

– The extent to which public goods should be provided at the local level is determined by the following three factors.


1. Tax-benefit linkages: The relationship between the taxes people pay and the government goods and services they get in return.

• High linkage: local roads

• Low linkage: Welfare payments


1. Tax-benefit linkages:

• If the tax-benefit linkage is low, the public good should be provided at the federal level. If not, the public good will be underprovided by the local governments.


2. Positive externalities/ spillovers

• The higher the externalities/spillovers, the better it is to provide the public good at the federal level.

• Example: police force and crimes.


3. Economies of scale

• The public goods with high economies of scale should be provided at the federal level.

• Example: national defense.

State and Local Government Expenditures-Redistribution across Communities

• If the Tiebout model is valid, we should not worry about redistribution, since each local community is providing public goods efficiently.


• However, if the Tiebout model does not perfectly describe reality, there are two arguments for redistribution:

1. Failures of the Tiebout mechanism: If there exist ‘frictions’ that prevent individuals to ‘vote with their feet’, then there may be some people ‘stuck’ in communities that provide less public good than they desire.

– If this is the case, redistribution is necessary.


2. Externalities: If a large share of local tax revenue is spent on a public good with spillovers, then the government should subsidize the localities that produce the externality.

• Example: public education.

State and Local Government Expenditures-Tools of Redistribution: Grants

• Example: Suppose that a town is providing only one public good, education, to its residents. The after-tax income of the residents is spent on private goods. Let the total welfare of the town equal $1 million.


• Initially:


1. Matching Grants: A grant, the amount of which is tied to the amount of spending by the local community.

• Effectively reduces the price of education to the town by half.

• The town increases its education provision.


1. Matching Grants:


2. Block Grants: A grant of some fixed amount with no mandate on how it is to be spent.

• Increases the wealth of the town leading to an increased provision of education.

• Assume that the grant amounts $350,000.


2. Block Grants:


3. Conditional Block Grants: A grant of some fixed amount with a mandate that the money be spent in a particular way.

• Increases the wealth of the town leading to an increased provision of education.


3. Conditional Block Grants:


• Comparing the three tools:

– The increase in the provision of the public good is highest in matching grants.

– Even though the provision does not increase as much with block grants, the town is better-off than matching grants.

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